TaxMatters@EY - November 2013

Making the most of investment losses

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Maureen De Lisser and Janna Krieger, Toronto

Tax-loss selling is a common year-end tax planning strategy used by investors to soften the blow of market downturns and bad investment decisions. By selling non-registered securities with accrued losses before the end of the year, you can shelter tax that might otherwise be payable on capital gains realized earlier in the current tax year, or recover tax paid on capital gains realized in the three preceding tax years.

The benefit of tax-loss selling is obvious — it puts money back in your pocket by reducing your 2013 tax bill or triggering a refund of 2010, 2011 or 2012 taxes. But there are some potential pitfalls and other important considerations.

The following are some reminders for investors looking to realize losses before the end of 2013.

Don’t let taxes drive an investment decision

Your decision to sell a security shouldn’t be primarily tax motivated. It must make sense from an investment perspective. You should review your investment portfolio to determine which loss securities are not meeting your investment objectives and are not likely to rebound. You should also consider the timeframe over which a security may be expected to rebound, as you may have the opportunity to sell and later repurchase the security.

However, be careful of the application of the superficial loss rules, which we discuss below. In addition, we recommend you consider the transaction costs and the risk that the security may rise in value prior to your repurchase. Consult with your financial advisor when making these decisions.

Assess your tax position to determine if you can benefit from the losses

Tax-loss selling only provides current savings if you otherwise expect to have net taxable capital gains for 2013 or have reported net taxable capital gains on your 2010, 2011 or 2012 tax returns. Review your trades in 2013 to determine whether your taxable capital gains exceed your allowable capital losses for the year.

If you’re in a net-loss position rather than a net-gain position for the current year, a tax-loss selling strategy will provide the greatest benefit if net taxable capital gains reported in 2010, 2011 and 2012 exceed the current net loss. The tax rules for determining capital gains and losses can be complex, particularly in relation to computing adjusted cost base, so you may wish to consult with your professional tax advisor when making this assessment. Good record-keeping is also important.

What if you only had capital losses in previous tax years?

Capital losses, once realized, do not expire. They may be carried forward indefinitely to be applied against capital gains in any year.

What if you review your portfolio and find a capital loss that you forgot to report in a previous year?

The Canada Revenue Agency (CRA) recently confirmed in a technical interpretation that “a net capital loss exists independently of whether or not it is reported in the tax return for the taxation year when it was incurred.” So even if that year is statute barred, you may be able to benefit from carrying forward those losses. Your EY advisor can help determine whether you can benefit from any losses you may find.

Making in-kind contributions to RRSPs or TFSAs

Securities transferred to an RRSP or TFSA are considered to have been disposed of at their fair market value on the transfer. While any resulting losses are denied, gains on those securities are taxable. If you have unused capital losses carried forward from previous years, using them to offset any gains on in-kind contributions may be an efficient way to rebalance your portfolio or make contributions when you don’t have extra cash but want to start accumulating tax-free earnings.

Be careful to ensure that any securities transferred to the registered plan are qualified investments (and not prohibited investments), and be mindful of your contribution limits so that you don’t find yourself offside with any anti-avoidance rules.

Watch out for the superficial loss rules

If you dispose of a security and realize a loss, and the same or an identical security is acquired by you, your spouse or common-law partner, a company either of you control, or an affiliated partnership or trust (such as your RRSP, RRIF, TFSA or RESP) — within the period beginning 30 days before and ending 30 days after the disposition (the 61-day period), and the security is still owned at the end of the period — the loss will be denied. This denied loss will be added to the adjusted cost base of the same or identical security acquired within this period.

According to the CRA, properties are identical if they are the same in all material respects, and a prospective buyer would not prefer one property over the other. For example, shares of the same class of the capital stock of a corporation or units of a mutual fund trust are viewed as identical properties. Although it’s a question of fact whether two securities are identical, it may be possible to sell units of one mutual fund and buy units of a sister fund (with similar types of underlying investments) without attracting the superficial loss rules.

Keep in mind that the superficial loss rules don’t apply to deny a loss realized on the disposition of property to your adult child. However, there must be real change in beneficial ownership in order for the transaction to be considered a disposition.

Consider using the superficial loss rules to your benefit

If you don’t have net taxable capital gains against which to apply possible capital losses, but your spouse or partner has gains in the current year or the three preceding years, you can use the superficial loss rules to transfer the loss to your spouse or partner. This planning works provided the attribution rules don’t apply to the transfer.

Consider the following example:

Tom owns 500 common shares of Pubco with a cost base of $11 per share. On 1 November 2013, the shares are trading at $7 per share. Tom can’t benefit from the potential loss, but his spouse Sally realized $3,500 of capital gains earlier in the year. Tom sells the 500 shares to Sally, for $7 per share, in exchange for a promissory note bearing interest at the CRA’s prescribed rate (since Tom receives fair market value consideration, the attribution rules won’t apply to the transfer).

On 2 December 2013, Sally sells all 500 shares on the open market for $6 per share (neither Tom nor Sally repurchases the shares within the next 30 days).

Tax consequences:

Proceeds of disposition (500 shares at $7 per share) $3,500
Adjusted cost base (500 shares at $11 per share) 5,500

Loss, denied by virtue of being a superficial loss

The $2,000 superficial loss is added to the adjusted cost base of the 500 Pubco shares Sally acquired:

500 shares at $7 per share $3,500
Superficial loss 2,000

Total adjusted cost base
On the sale of shares:  
Proceeds of disposition (500 shares at $6 per share) $3,000
Adjusted cost base 5,500
Capital loss ($2,500)

Because neither Tom nor Sally owned any Pubco shares on 1 January 2014 (30 days after Sally’s disposition), Sally is able to use the $2,500 capital loss to offset a portion of her $3,500 capital gains realized earlier in 2013.

Sally needs to ensure the 2% interest on the prescribed rate loan from Tom (calculated as $3,500 x .02 x 61/365 = $12, assuming the loan was outstanding from 1 November 2013 to 31 December 2013) is paid before 30 January 2014 to ensure the attribution rules do not apply.

Don’t miss the 2013 tax-loss selling deadline

In order for capital losses to be realized in the current tax year, the disposition of the related securities must occur in 2013. For stock exchange transactions, the CRA generally considers the settlement date (rather than the trade date) to be the date of disposition. Since security trades are subject to a three-day settlement period and Canadian markets are closed on Christmas Day and Boxing Day, the last day to execute a trade on a Canadian exchange that would settle in 2013 is Tuesday, 24 December (26 December for US exchanges).

We recommend that you start planning now in order to implement an effective tax-loss selling strategy.